Where to find opportunities in a resource-rich stock market

AshleyP. Lau

Toronto's benchmark index last week hit a two-year high not long after gold futures soared above $1,400 an ounce, crude oil settled at its two-year best, and corn saw its tightest supply-and-demand balance in 14 years.

Energy and mining stocks, considered the backbone of the broader Canadian market, have emerged as leaders in the rally. The TSX main mining index (TTMN) alone jumped more than 40% from a trough in late August to a peak in early November on the back of strong buyers interest in metals.

But the resource rally is both a gift and a curse for the North American giant, which is susceptible to the swift pricing shifts that can affect commodities.

That sensitivity was highlighted this week after China’s decision to raise its banks’ reserve requirements dragged gold and oil futures down. The rate hike suggests that China is reigning in its fast-growing economy, which could hinder emerging-market demand for commodities. Read about China’s rate hike

“Markets have been treading higher,” said Fergal Smith, a Toronto-based market strategist with Action Economics. “But China is on a course of tightening monetary policy, and the scale and impact are still filtering through the market.”

The S&P/TSX Composite Index ($ISPTX), the main gauge of the Canadian market, already slid from its 13,114 peak last week to close Friday at 12,956 — still significantly higher than its earlier year range. If the index can maintain support at the 12,505 level and not fall further, the market could be in for another rally, Smith said.

“It looks like the reversal has already started,” added Colin Cieszynski, a Toronto-based marketing analyst with CMC Markets Canada, in reference to the market’s momentum. “There was a run up in it and now it’s beginning to come back.”

How long Canadian stocks can sustain their latest advances, and whether this week’s commodities tumble will be a short correction or a prolonged retreat, is key to the outlook for the Canadian market, analysts say. See MarketWatch’s Canada page

All eyes on oil and gold

Canada’s energy and mining sectors are at the core of the market’s recent gains.

“The commodities rally has been stronger than expected.” said Peter Buchanan, a senior economist at CIBC World Markets in Toronto.

The run-up in metals prices pushed Canadian mining giants Barrick Gold Corp. (ABX), Agnico-Eagle Mines Ltd.(AEM) and Goldcorp Inc. (G) to record third-quarter profits in late October. Goldcorp's quarterly net income quadrupled and the company announced a 100% increase in its annual dividend.

“The Canadian market got another shot in the arm from better-than-expected earnings,” Buchanan said.

Suncor Energy (SU) shares soared 8.9% the day after the company reported third-quarter earnings. Goldcorp and Agnico-Eagle saw similar reactions, with Goldcorp shares up 5.9% and Agnico-Eagle’s stock climbing 6.6%.

CMC Markets’ Cieszynski described the miners as basically “rallying in tandem with gold.”

On the oil front, Canada’s lucrative oil sands regions have fueled Canadian producers, as well as sparked interest from foreign companies interested in oil opportunities in Canada.

The Claymore Oil Sands Sector ETF (CLO), which tracks companies focused on oil sands production, reached a six-month peak in November. Also riding the highs, the iShares S&P/TSX Capped Energy Index Fund (XEG) traded at its nine-month best in November.

“This was one of our strongest quarters for oil sand production in Suncor's history,” the company’s CEO Rick George said in a statement earlier this month.

Smaller Canadian companies involved in oil sands development have also seen a boost over the past quarter. Canada’s Connacher Oil & Gas Ltd. (CLL) last week reported a 46% jump in its third-quarter cash flow from the year-ago period.

Oil and gold have also been somewhat immune to the Canadian dollar’s tread towards parity with the greenback — which typically hurts Canadian exports priced on the loonie. But since metals and oil are priced in U.S. dollars, the commodities have remained relatively unscathed from the Canadian dollar’s movement. See the latest global currency movements

Financials are a force

Beyond a commodities boom, Canadian financial-sector strength and overall economic forces have also paved the way for the country’s resource stocks.

While the U.S. financial system battles its way back to health, the Canadian banking sector stands in a relatively robust position. As Industry Canada Minister Tony Clement noted at a news conference earlier this week, Canada enjoys low business tax rates and a low debt-to-GDP ratio.

“Canada’s value proposition to foreign investment is very, very high,” the minister said. “I think the highest in the world quite frankly.”

The global appeal of Potash Corp. of Saskatchewan (POT)
POT, -2.26%
the world’s largest fertilizer company and one of Canada’s crown jewels, is a prime example. The potash giant has been the target of two separate unsolicited offers recently, from mining giant BHP Billiton
BHP, -1.72%
and China’s state-owned Sinochem Corp. Both bids were withdrawn.

Analysts at Greenwich Associates said earlier this week that Canadian corporations are in a sweet spot, with “big cash positions” and “favorable credit conditions” that have them poised for merger and acquisition activity on both domestic and international fronts.

“The improvement in corporate access to bank financing has been dramatic over the past 12 months,” Greenwich Associates’ Jay Bennett said in a research note.

While the U.S. finds itself reaching deeper into its pockets to drum up extra stimulus and the European Union is tending to Ireland’s debt, Canadian economic and market fundamentals are relatively intact, analysts say.

“Investors had been on a good ride leading up to QE,” said TD Securites economics strategist Millan Mulraine, referring to investors’ anticipation of the Fed’s $600-billion “quantitative easing” stimulus plan.

Future shocks

The Canadian market’s peak earlier this month may have been what Cieszynski called a temporary “bull trap,” when investors get a false sense of market momentum, only to have stock prices reverse.

“It’s a sign of market exhaustion and a bit of a correction,” he said.

Analysts at RBC Capital Markets believe the Canadian market’s rally will hold, especially in the materials sector, which includes mining companies.

The iShares S&P/TSX Capped Materials Index Fund (XMA), which includes securities in the Canadian materials sector, reached a five-year high in November.

“This sell-off does not represent the beginning of the end for the economic and equity market cycle,” the RBC analysts said in a research note. “Most leading economic data have stabilized and positive economic growth offers a set up which has infrequently been associated with a sustained bear market.”

The candidates were chosen based on growth, momentum and earnings quality, the analysts said.

Moody’s Investors Service on Wednesday also gave a nod to Teck Resources, upgrading its rating for the company to Baa2, citing a “stable outlook.”

”The conditions within the metals and coal markets are favorable and will allow Teck the financial flexibility to balance its uses of free cash flow between investment plans, debt repayment and potential acquisitions,” the rating agency said in a note.

Taking cues from the global economy

How long Canada can sustain its market momentum is now largely in the hands of global economic forces, analysts say, which tend to hold the puppet strings on commodities trends.

“There’s a global sentiment happening now,” said TD Securities’ Mulraine, noting that any policy tightening from China could put a damper on commodities price movements and underlying equities markets.

Canada is often known to ride the waves of U.S. sentiment and has increasingly been linked with its North American counterpart. As the saying goes, whenever the U.S. markets sneezes, it’s not long before Canada catches a cold.

“If both Canadian and U.S. employment data is coming out, traders will sit on their hands until they get the U.S. report,” Mulraine said.

Three international forces are most at play in the Canadian market right now, Action Economics’ Fergal said: The scale and impact of the Fed’s quantitative-easing campaign; increased risk aversion in the wake of Ireland’s debt woes; and any movement from China’s economic policymakers.

Demand from China, the world’s leading emerging market, has also been a driving force behind advancing oil and metal prices. Canada’s resource-heavy stock market would likely take a battering from any slowing in the Chinese economy.

The impact would also weigh on Canadian-stock ETFs and funds. The iShares MSCI Canada Index ETF
EWC, -0.69%
a measure of the broad Canadian market, rallied with the TSX when it reached a two-year high in November.

“ETFs and mutual exchanges all could move sideways with the slowdown expected in China,” Mulraine said.

Intraday Data provided by SIX Financial Information and subject to terms of use.
Historical and current end-of-day data provided by SIX Financial Information.
All quotes are in local exchange time. Real-time last sale data for U.S. stock quotes reflect trades reported through Nasdaq only.
Intraday data delayed at least 15 minutes or per exchange requirements.